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Market Review: Can the local sharemarket continue to outperform?

By Anthony Quirk

Friday 8th October 2004

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The contrast in domestic and overseas sharemarket and bond performance has continued.

Once again the New Zealand sharemarket performed strongly, with the NZSX50 Index up 3.1% for the month and 24.3% for the year. After starting the month well, global equity markets retreated and finished with a return of 1.3% for September, with a 14.2% return for the year (MSCI in local currency terms). The strong kiwi dollar completely eroded this twelve month return for unhedged investors.

The reverse is true with bonds. The local market has consistently under performed the global bond market and this trend continued in September. The local market returned 0.7% for the month (NZX Government Bond Index) and 4.2% for the year. Global bonds (Lehman Global Aggregate Index) returned 0.8% for the month and 7.7% for the year.

But this is the past what of the future?

A key issue to answering this, as always, remains the interest rate outlook. The domestic bond market has struggled to cope with five interest rate rises by the Reserve Bank so far this year. However, there is a growing feeling that the tightening cycle may be nearing its end, with probably only one more rate rise to come.

This is on the basis the housing market is starting to cool, immigration levels have fallen significantly and the strong kiwi dollar is hurting export returns. Combine this with a possible slow down in the global economy in 2005 and it is now more likely that the Reserve Bank may start to decrease rates in mid-to-late 2005.

In such an environment the domestic bond market has probably endured its maximum "pain" over the past 18 months and returns for the next year should be healthier. In fact, history shows that domestic bonds start to perform better before the tightening cycle is complete.

In contrast, global bond markets face the prospect of a tougher twelve months, with the possibility of Federal Reserve rate rises continuing for some time. While the magnitude of the rate increases in store for the United States is uncertain, it is still likely to be greater than any future rises in New Zealand. All going well for the US economy, the tightening cycle still probably has some way to go, given how low rates are by historic standards.

Thus, bond market performances may be reversed over the coming twelve months, with the US bond market possibly about to go through a similar tough period to that endured by the New Zealand market recently.

A topping out of interest rates in New Zealand could mean the kiwi dollar peaks over the next six months before easing in anticipation of falling interest rates later next year. A further hurdle for the kiwi dollar to overcome is the unwelcome return of a large current account deficit for this country. For the year ending June, New Zealand's current account rose to 4.6% of GDP, with some forecasters concerned that it could exceed 5-6%, a figure where a country's currency should come under pressure. However, such a scenario for the kiwi may be offset by continued weakness in the US dollar as that country continues to grapple with its twin deficits (fiscal and current account).

In terms of the sharemarkets, the New Zealand equity market has done very well to cope with the rise in interest rates and a strong kiwi dollar. This is has occurred because of very strong earnings growth in most sectors. However, average market valuations have now risen to a point where it is much harder to find "cheap" stocks. Any hint by a company of weakening earnings performance could be hit hard in such an environment.

At this stage of the domestic sharemarket, interest rate and economic cycles, it may be worth looking at high yielding stocks, in anticipation of interest rates easing later next year. Given sharemarkets generally anticipate economies 6-12 months ahead of time, some yield stocks may start to perform better than (currently) more highly rated companies.

Global equity markets are being weighed down by oil prices hitting US$50. Such prices are effectively an extra "tax" on consumers and is partly why there are concerns on whether US consumer spending is slowing. With the US consumer making up over 70% of that country's economy (or GDP) this would be a significant head wind to overcome.

The bounce from the over-sold levels for the US sharemarket of a few years ago is now well and truly over and average US company valuations are once again relatively high. Combine this with rising interest rates, slowing US consumer spending and easing earnings growth rates and the twelve month outlook looks tough. Moreover, the European and Japanese economies are sending mixed growth outlook signals at present.

So, it is hard to see global equities doing anything other than struggle over the next year. This means the marked contrast in performance between domestic and global markets may be coming to an end, more because of lower returns from the former than a surge in the latter. Any fall in the kiwi dollar would also help global equities redress the balance.

The US presidential election outcome is unlikely to dramatically change the above. Bush is regarded as more business friendly and would be a slight positive for the markets and the economy. However, the reality is if Kerry wins, his ability to implement any significant anti-business legislation will be hindered by the likelihood of the Republicans controlling both the House and Senate. Also, politicians are increasingly finding their policies must take account of market (and Central Bankers!) scrutiny, ensuring they remain relatively orthodox.

The wild card in all of the above remains China. Its increasing importance and impact on the world economy and global markets is undoubted. It has the potential to be the world's largest economy through this century and is already a major importer, which is a key driver of commodity prices at present.

In the short term China may have a negative effect on global growth as authorities are attempting to slow down its economy. There are mixed signals on whether this is being successful, including whether a "hard" landing will occur. Trying to establish exactly what is happening is difficult to say the least, not helped by the opaque statistics released in that country! The outcome is a significant factor to consider, certainly more important than the US Presidential election for example, a situation that would have been hard to contemplate just over a decade ago.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Review here

Anthony Quirk is the managing director of Tyndall Investment Management New Zealand Limited (Tyndall).



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